Data Processing for an Exchange Traded Fund

ABSTRACT

An accounting system allows posting transactions to a general ledger of an Exchange Traded Fund. The accounting system includes a computer-assisted process that nets subscription and redemption orders that occurred over a particular time (e.g., one day) and records a transfer of securities into or out of the fund based on the net of the subscription and redemption orders.

CROSS-RELATED APPLICATION

Under 35 U.S.C. 119(e)(1), this application claims the benefit ofprovisional application Ser. No. 60/612,194, filed Sep. 22, 2004entitled, “Data Processing for an Exchange Traded Fund.”

TECHNICAL FIELD

This description relates to exchange traded funds.

SUMMARY

In one aspect, the invention features an accounting system for postingtransactions to a general ledger of an Exchange Traded Fund. Theaccounting system includes a computer-assisted process that netssubscription and redemption orders that occurred over a particular time(e.g., one day) and records a transfer of securities into or out of thefund based on the net of the subscription and redemption orders.

In one particular implementation, the accounting system selectssecurities held by the fund for redemption based on the cost basis ofthe securities held by the fund if there is a net redemption of sharesof the fund.

In another aspect, the invention features a computerized accountingsystem for an ETF that ranks lots of the security held by the fund basedon the tax liability of each lot and selects lots of the security basedon whether the trade order is an order to sell the security or an orderto redeem the security. Such a tax lot selection method is particularlyadvantageous in the context of an ETF since there are different taximplications depending upon whether the securities are transferred outof the fund due to a sale (which incurs a tax liability to the fund)versus due to a redemption (which does not incur a tax liability).

In one particular implementation, the accounting system selects tax lotshaving the lowest cost basis if the order is a redemption and selectstax lots having the least tax liability if the order is a sale.

DESCRIPTION OF DRAWINGS

FIG. 1 is a diagram illustrating the exchange of shares of an ExchangeTraded Fund on a primary and secondary market.

FIG. 2 is a diagram of an implementation of an ETF.

FIGS. 3-4 are flow charts illustrating accounting processes for an ETF.

DETAILED DESCRIPTION

An Exchange Traded Fund, or ETF, is a hybrid investment vehicle thatcombines characteristics of both open and closed end funds. Like anopen-end mutual fund the ETF provides investors with its net asset valueonce daily, but similar to a closed end fund it also lists its shares ona secondary market such as an exchange. Thus an ETF may be bought andsold in the primary market directly from the ETF via a marketintermediary referred to as an Authorized Participant (or AP), or on asecondary market at market prices which fluctuate based on supply anddemand.

APs in the primary market purchase large increments of shares (referredto as Creation Units), while secondary market shares are available toindividual investors involving transactions in smaller share incrementsvia brokers.

As part of their investment strategy, ETFs may seek to track aparticular stock market index, such as the NASDAQ Composite Index. Toaccomplish this index tracking, ETFs commonly bundle together the someor all of the constituent securities that are part of the index in theETF's investment portfolio.

Investment company sponsors, such as Fidelity Investments®, may offerdifferent types of funds that each issue shares representing the sameportfolio of assets. For example, an investment company sponsor mayoffer a traditional open-end mutual fund and an ETF that both track theNASDAQ Composite Index. Similarly, if eventually permitted by securitiesregulations, an investment company sponsor may want to offer anETF-version of an actively managed open end fund, such as the FidelityMagellan® fund. Because the two (or more) funds represent the sameportfolio of assets, it may be advantageous for an investment companysponsor to pool the funds' assets into a single “master” trust toachieve certain economies of scale, which ultimately could lead to lowermanagement fees for both funds.

As shown in FIG. 1, an Exchange Traded Fund 100, for example theFidelity® NASDAQ Composite Index® Tracking Stock, is part of a trust 102that holds the assets of the fund. The ETF 100 is managed by thePortfolio Manager 104, and receives a number of services 106 such asaccounting, tax, and legal.

The ETF 100 issues and redeems shares to APs 108 a, 108 b in largeincrements termed Creation Units via the Depository Trust Company or theContinuous Net Settlement System of the National Securities ClearingCorporation. Purchases of Creation Units are made by tendering a basketof designated stocks to the fund (known as Deposit Securities) inexchange for a Creation Unit. The fund's Portfolio Manager 104 createsthe list of Deposit Securities that an AP must deliver tomorrow in orderto exchange for one Creation Unit (a block of 100,000 shares) of theETF. Similarly, a Creation Unit may be redeemed by an AP presenting theCreation Unit of the ETF (e.g., a block of 100,000 shares) in return fora basket of stocks which should approximate the composition of theNASDAQ index (in the case where the ETF tracks the NASDAQ index).

Both the subscription and redemption of Creation Units are known as“in-kind” transactions in the ETF since payments are made in-kind via abasket of securities, along with a smaller cash component. The cashcomponent (sometimes referred to as the Balancing Amount) is equal tothe difference between the NAV of a Creation Unit (as calculated by aNAV Generator) and the market value of the Deposit Securities on the daythe subscription or redemption transaction takes place. The BalancingAmount serves to equalize the amount paid for a Creation Unit with thevalue of the Creation Unit itself. Unlike typical mutual fund purchaseand sale transactions involving cash, subscription and redemptiontransactions of Creation Units are not taxable events for the fund undercurrent Federal tax law.

As shown in FIG. 2, an Exchange Traded Fund is implemented via an ETFCustodian System 202, an ETF Back office System 204, an ETFBroker/Dealer system 206, an ETF Advisor System 208, and a ClearingAgent System 210.

The ETF broker/dealer system 206 is maintained by a licensedbroker/dealer associated with the ETF, such as National FinancialServices (NFS), and is configured to receive subscription and redemptionorders from Authorized Participants in the fund, such as AuthorizedParticipant 220. Authorized Participants may place subscription orredemption orders with the Broker/Dealer System 206 between specifiedhours during a trading day, for example, between 9:00 am and 3:00 pm. Asthe Broker/Dealer System 206 receives creation unit orders fromAuthorized Participants during this time, it records each orders in afile called the CU Order file. At the end of order period, theBroker/Dealer System 206 transmits the CU Order file to the ETF BackOffice System 204 and the ETF Custodian System 202. The ETF CustodianSystem 202 executes each of the CU orders on the next trading daythrough Clearing Agent 214. When an Authorized Participant receives acreation unit, it may list shares of the ETF on a listing exchange 222,e.g., NASDAQ, where individual investors 226 may trade ETF sharesthrough various broker/dealers 224.

The ETF advisor system 208 is associated with the Portfolio Manager ofthe ETF and provides two functions. First, the ETF Advisor System 208executes trades directed by the Portfolio Manager (typically through aclearing agent) and transmits a record of these trades to the CoreAccounting System 216 through the Custody System 212. Second, the ETFAdvisor System 208 determines once per trading day (i) the basket ofsecurities plus (ii) an estimated balancing amount (or cash component)necessary to acquire a Creation Unit on the next trading day. The ETFAdvisor System records the basket of securities in a text file named theDeposit Securities file and transmits this file to NAV Generator 218 inthe ETF Backoffice System 204. The ETF Advisor System 208 alsodisseminates both pieces of information (i.e., the basket of securitiesand estimated balancing amount) to the Authorized Participants, whichprovides the Authorized Participants an estimated “price” of a creationunit for the next day (although the actual price may vary because theactual balancing amount is not known until the end of the trading day onwhich the order was placed when the daily NAV is computed).

The ETF Custodian System 202 is maintained by the trustee of the ETFand, as mentioned above, receives the CU Order File from the ETFBroker/Dealer System 206. The ETF Custodian System 202 settles each ofthe orders listed in the CU Order file through Clearing Agent 214 totransfer the underlying basket of securities plus the balancing amountinto or out of the fund. In some instances the actual cash component maybe negative, which in the case of a subscription transaction, would meanthat the ETF would pay the Authorized Participant the cash component,and in the case of a redemption transaction, would mean that theAuthorized Participant would pay the ETF the cash component.

The ETF back office system 204 includes a Core Accounting System 216, aNet Asset Value (NAV) generator 218, and a Custody System 212.

The NAV Generator 218 receives the closing prices of securities fromvarious exchanges and computes the daily NAV for the ETF based on thenumber of outstanding fund shares and the securities held by the fundand their closing prices. The NAV Generator 218 also receives and storesthe Deposit Securities files (which lists the identity and amount ofeach required security) and computes the Portfolio Composition File(PCF), which, includes the quantity of each of the requisite DepositSecurities and the actual balancing amount necessary to acquire acreation unit. The PCF is distributed to the ETF Broker Dealer 206 andthe ETF Custodian 202 (via the Custody System 212).

The NAV Generator 218 is also configured to provide the DepositSecurities file and the closing prices of various securities to the CoreAccounting System 216, which, as explained in more detail below, usesthis information to post net subscription and redemption transactions tothe fund's General Ledger 217.

The Custody System 212 receives the Portfolio Manager Trade file fromthe ETF advisor system 208 and forwards it to the Core Accounting System216 for posting to the General Ledger 217. The Custody System 212 alsoreceives a Trade Reconciliation file from the Clearing Agent System 210,which is used to reconcile actual trades conducted via the ClearingAgent with transactions posted to the general ledger by the CoreAccounting System 216.

The Core Accounting System 216 maintains the General Ledger 217, aTransaction History file 215 and a Tax Lot Inventory file 219. TheTransaction History file provides the principal audit trail of trade andadjustment activity for the entire life of every tax lot created. Itincludes all trade-based transactions of the fund, such as buys andsells, as well as information about non-trade based core accountingactivities, such as corporate actions, mark-to-market activity, andinternally generated cost adjustment transactions. Each record in theTransaction History file includes three parts. The first part containsthe data about the actual trade such as the transaction type (e.g.,buy), CUSIP number of the security, trade date, settle date,quantity/par of the trade and execution price. The second part of therecord contains tax lot information for the trade, including theoriginal, book, and tax cost information. The third part of the recordcontains position level data related to the average cost positions forthe fund's holdings in the affected CUSIP identification.

The Tax Lot Inventory file 219 provides a comprehensive list of thecurrent tax lot positions of the ETF. Tax lots that have been disposedof by the ETF are purged from the file and thus only open tax lostpositions are maintained in the Tax Lot Inventory file. Each tax lotrecord maintained in the Tax Lot Inventory file 219 includes data aboutthe current quantity and cost basis for each tax lot. The cost basis forthe tax lots reflect all sales, cost adjustments and amortizationaccruals that have occurred since the tax lot was purchased.

In operation, the ETF Advisor System 208 determines at the close of eachtrading day the basket of securities and an estimated balancing amountrequired to acquire a Creation Unit for the next trading day and createsa text file, called the Deposit Securities file, that lists the quantityrequired for each security. For example, if the ETF tracks the NASDAQComposite Index, ETF fund manager would require that the basket ofsecurities include a certain quantity of the securities that make up theNASDAQ Composite Index. For some securities that comprise the NASDAQComposite Index, the ETF fund manager may not include any shares in thebasket of securities, especially where the percentage of the indexweight of the security is very small. Thus, for example, if “XYZ Corp.”comprises only 0.0002% of the NASDAQ Composite Index, the ETF fundmanager may choose not to require any shares of this company within thebasket of securities tendered for a CU.

At the same time the ETF Advisor System 208 determines the requisitebasket of securities, it also estimates the balancing amount that willbe required for each CU transaction and disseminates both the basket ofsecurities and estimated balancing amount to the AuthorizedParticipants. In addition, the ETF Advisor System 208 transmits theDeposit Securities file to the NAV Generator 218, where it is stored.

The NAV Generator 218 computes both a NAV of the fund and a PortfolioComposition File at the end of each trading day. The PortfolioComposition file includes Deposit Securities file and the actualbalancing amount for CU orders placed on the trading day. The NAVGenerator 218 computes the actual balancing amount by multiplying thenet assets of the ETF by the number of shares per CU and dividing by thenumber of outstanding shares and then subtracting the value of theDeposit Securities file. The NAV Generator 218 transmits the PortfolioComposition File to the ETF Custodian System 202 and ETF Broker/DealerSystem 206 via the Custody System 212.

The ETF Advisor System 208 lists all trades, if any, executed by thefund manager during the trading day in the Portfolio Manager Trade fileand transmits this file at the end of each trading day to the CoreAccounting System 216 through the Custody System 212.

At the end of a trading day, the ETF broker/dealer transmits the CUOrder file (which lists all of the Creation Unit orders received for theday) to the Core Accounting System 216 and the ETF Custodian System 202.

Referring to FIG. 3, the Core Accounting System 216 receives the CUOrder file, Deposit Securities file, and close prices for the basket ofsecurities at the end of each trading day. The Core Accounting System219 reads the CU Order file and nets 302 the subscription and redemptionorders to a single value. If the subscription and redemption orders netto zero, the process ends 304 and no redemptions or subscriptions areentered into the fund's general ledger.

If the subscription and redemption orders do not net to zero, the CoreAccounting System builds 306 a list of transactions that require entryin the general ledger based on the net subscription and redemptionorders, the required amount of deposit securities, and the close pricesof the deposit securities. In particular, the Core Accounting Systemtakes the securities in the basket (provided in the Deposit Securitiesfile received from the NAV Generator) and multiplies them by the netCreation Units and their respective closing price (also received fromthe NAV Generator). For example, if there is a net of two (2)subscription orders for the day and if the ‘basket’ calls for 1,000shares of Microsoft® Corporation as part of the delivery and thesecurity closed at $50.00, the Core Accounting System would create asubscription in kind transaction for 2,000 shares of Microsoft at a costof $100,000 (i.e., 1,000×2×$50.00). In the event that there was a net oftwo (2) redemption orders, the Core Accounting System 216 would create aredemption in kind for 2,000 shares at $50.00 per share. After buildinga list of redemption/subscription transactions, the Core AccountingSystem suspenses 308 the net subscription/redemption orders for postingto the general ledger along with any other transactions the need to beposted to the general ledger.

As shown in FIG. 4, the Core Accounting System processes every nightafter trading all suspensed transactions for posting to the generalledger. The suspensed transactions include not only the redemption orsubscription in kind transactions, but also any buys, sells, puts,calls, cancels, re-bookings (i.e., a transaction that was mistakenlybooked to another fund), wash sales, expires, short sells, cover shorts,paydowns, payups, maturities, cost adjustments, open futures contracts,close futures contracts, receives, delivers, or other transactions thatrequire posting to the general ledger.

Referring to FIG. 4, the Core Accounting System arranges 402 thesuspensed transactions by transaction date and then selects 403 theearliest transaction date. The Core Accounting System then arranges 404the suspensed transactions for the selected date by transaction type(e.g., redemption in kind, subscription in kind, buys, sells, etc.).While most of the suspensed transaction occur on same day in which thenightly processing occurs, occasionally transactions that occurred on aprevious day must be processed for posting to the general ledger. Forexample, a previous transaction may have been mistakenly booked toanother fund and would have to be rebooked to the proper fund.

The Core Accounting System processes 405, 406 each transaction type(e.g., buy, sell, net redemptions/subscriptions, etc.) for posting tothe general ledger. As the Core Accounting System processes thesuspensed transactions, it determines 407 if the transaction transferssecurities out of the ETF. Sell transactions and redemption transactionsare examples transactions in which securities are transferred out of theETF. If the transaction type does not transfer securities out of theETF, then the Core Accounting System records 408 the transaction to thegeneral ledger. For example, if the transaction type is a buy, the CoreAccounting System will write the date and time of the transaction, anidentification of the security purchased, the amount of sharespurchased, the price paid per share, and other transaction-relatedinformation as an entry in the general ledger database. Similarly, ifthe transaction type is an open futures contract, the Core AccountingSystem will write the date and time the contract was purchased, anidentification of the underlying security, the contract price and thecontact date as a separate entry in the general ledger database.

If the Core Accounting System determines 407 that the transactiontransfers securities out of the ETF, it queries 410 the Tax LotInventory file obtain the lots of the security which is to betransferred out of the fund.

The Core Accounting System also determines 411 if the transaction typeis a redemption in kind. If the transaction is a redemption in kind,then the Core Accounting System, in this particular implementation,sorts 412 the tax lots (from the Tax Lot Inventory file) from the lowestcost basis to the highest cost bases and selects 414 the lot(s) havingthe lowest cost bases for posting 408 to the general ledger. based on apredetermined designation, which is typically elected by the PortfolioManager. In another implementation, the Core Accounting System rankslots of the security having the highest potential tax liability byfactoring in the cost basis and whether the tax lot is subject tolong-term or short term capital gains and then selects one or more lotsof the security having the highest potential tax liability for postingto the general ledger.

If the transaction type is not a redemption in kind, the Core AccountingSystem sorts 416 and selects 418 tax lots based on a preselectedpreference for the fund, which may be determined by the PortfolioManager. In many cases, the predetermined preference for a fund is forthe accounting system to select lots of securities yielding the greatesttax advantage for the fund. In this case, the Core Accounting Systemsorts the lots based on potential tax liability. In this regard, theCore Accounting System multiplies the unit cost for each lot by thepotential gain or loss on each unit (using the current close price ofthe security). For lots that have been held for less than a year (andthus subject to short term capital gains or losses), the core accountingsystem multiplies the potential loss or gain lots by 1.8, which is theshort term capital gain tax rate (0.36) divided by the long term capitalgain tax rate (0.20). This factor is subject to change based on currenttax rates. After sorting the lots based on potential tax liability, theCore Accounting System 216 selects 418 one or more lots of securitieshaving the lowest potential tax liability to record for the sale. Othertax lot selection algorithms may be specified for the fund, includingselection of lots having the highest cost, lowest cost, minimum gain,maximum gain, and minimum tax.

After selecting the lots for potential sale, the Core Accounting Systemruns 420 a wash sale process on the selected lots. The wash sale rulespecifies that a taxpayer cannot claim a loss on a security that wasbought back within 30 days, and, therefore, the wash sale processexamines (i) purchases to the fund and sales from the fund sold at aloss traded within the prior 30 days that have not been applied toanother wash sale and (ii) sales at a loss and purchases traded withinthe prior 30 days that have not been applied to another wash sale.Adjustments are made on the purchase lots cost basis for the amount ofthe disallowed loss and holding period to include the period held on thedisallowed loss. After the wash sale process is applied to the selectedlots, the transaction is posted 408 to the general ledger using theselected lots.

The core accounting system repeats this process for each suspensedtransaction until all of the suspensed transactions are posted to thegeneral ledger.

A number of embodiments of the invention have been described.Nevertheless, it will be understood that various modifications may bemade without departing from the spirit and scope of the invention.Accordingly, other embodiments are within the scope of the followingclaims.

1. A machine-implemented method for accounting for in-kind transactionsof an Exchange Traded Fund, the method comprising: netting subscriptiontransactions and redemption transactions that occurred over a particulartime; and recording a transfer of securities into or out of the fundbased on the net of the subscription and redemption transactions thatoccurred over the particular time.
 2. The method of claim 1 furthercomprising: selecting securities held by the fund for redemption basedon the cost basis of the securities held by the fund if there is a netredemption of shares of the fund.
 3. A machine-implemented method foraccounting for in-kind transactions that occur in an exchange tradedfund, the method comprising: receiving orders to acquire one or morecreation units over a particular time period, wherein each acquisitionorder represents a transfer of a basket of securities into the fund;receiving orders to redeem one or more creation units over theparticular time period, wherein each redemption order represents atransfer of a basket of securities out of the fund; and recording anin-kind transaction based on the net number of orders to acquire andredeem creation units.
 4. A machine-implemented method for selecting oneor more lots of a security held by an exchange traded fund, the methodcomprising: receiving an order to transfer a lot of a security out ofthe fund; ranking lots of the security held by the fund based on the taxliability of each lot; and selecting one or more lots of the securitybased on whether the trade order is an order to sell the security or anorder to redeem the security.
 5. The method of claim 4 wherein selectingone or more lots of the security based on whether the trade order is anorder to sell the security or redeem the security comprises: determiningwhether the order is an order to sell the security or redeem thesecurity; if the order is an order to redeem the security, thenselecting one or more lots of the security having the lowest cost basis.6. The method of claim 5 further comprising: if the order is an order tosell the security, then selecting one or more lots of the securityhaving the least tax liability.
 7. The method of claim 4 furthercomprising: recording a selected lot of the security as a transaction.8. A machine-implemented method for selecting a lot of securities heldby an exchange traded fund, the method comprising: receiving an order totransfer a lot of a security out of the fund; ranking lots of thesecurity held by the fund based on the tax liability of each lot; andselecting one or more lots of the security based on whether the tradeorder is an order to sell the security or redeem the security.